24 January 2010

Startup Business Development Strategies: 7 Tips For Putting Together Stellar Deals

Business development is fun.  Putting together partnership deals requires a special combination of hustle, strategic thinking, technical chops, project management, and sales and negotiation skills.  It’s a bit like a triathlon, in that it stretches your abilities in multiple arenas.

Business development is both creative and analytical—left brain and right brain—and done well, business development deals can be the purest representation of the equation “1+1=3” to drive growth.

A few tips for startups doing deals:

1.   Focus on the right targets. 
Any meaningful partnership deal will require a significant amount of time and attention from your management team.  This places a real constraint on the number of potential partnerships you can chase down at any given time, especially if you’re trying to simultaneously keep the business afloat, hire staff, raise money, and manage all the other critical-path activities that startup founders are responsible for.

As such, the “shotgun strategy” does not work well for startups; you’ll waste time fielding exploratory tire-kicker meetings that lead nowhere, or worse, you’ll find yourself paying attention to the firms who respond to inquiries quickly only because of some underlying flaw in their business (for example, they are struggling and desperate for something to move the needle—an ‘adverse selection’ problem).

Since a founder’s time is his or her greatest constraint, it becomes critical to instead take a “sniper’s approach,” and carefully select a short list of partners who will deliver the most bang per bullet.  Strategic targeting—instead of being reactive to those chasing you—front-ends the bulk and burden of your work, but ultimately delivers a better investment return on your time and effort.  Selective hunting keeps you focused on the game that really matters.

2.   Come to the table from a position of strength.
Startups are often at a disadvantage when forming partnerships with larger companies, due to the simple fact that they are startups.  There is a natural bias against working with firms that are unproven, underfunded, and still developing and/or evolving.  The best way to compensate for the ‘startup stigma’ is to bring something special to the table—an asset that cannot be easily replicated by another firm.

An “asset” can take many forms, both tangible and intangible: it could be an innovative technology that plugs a critical gap in your partner’s product line; it could be access to a market segment or demographic that you have been able to crack, but others haven’t; it could be the brand and “buzz” that you are generating with your business; or it could be a combination of all three.

It is remarkable how much attention a startup can garner when it has something noteworthy, and how frustratingly little a startup can get when it is another minnow in a school of similar-looking fish.  The two situations contrast starkly with one another:  the challenge of the first is not being able to handle the avalanche of in-bound inquiries; the challenge of the second is that your emails are never returned and your phone calls never answered.  There is rarely a middle ground here. Thus, if you don’t currently have something noteworthy as your ace card, go back and continue developing or marketing until you do, so as to avoid a slow, painful drain on your time and resources, and motivation.

3.   Get creative. 
One of the best things about being a startup founder is that you (generally) have the leeway and latitude to write your own script.  Contrast this to a partnership deal between two well-established companies, where there are already formalized processes and procedures—in short, “rules”—for doing deals.  As a startup, especially if you’re in a new or emerging space like social media or online radio or video, you have the ability to make it up as you see fit.

Indeed, the best business development deals are often those that break new ground and introduce new models for doing business.  Follow the rules of brainstorming, where no idea is a dumb one, and explore all sorts of possibilities; as long as the contemplated deal structure benefits both parties, it’s worthy of consideration. Set aside your predilections and constraints and get creative.

4.   ”Ask not what your partner can do for you--ask what you can do for your partner.”
Before pursuing any deal, it is useful to get inside the mind of your target partners, and view a potential deal from their perspective.  What is it they are lacking?  Where are they falling behind?  What keeps them up at night?  This takes research and an ability to connect the dots of an often-complicated mosaic of market trends, products, competitors, company culture, and other factors.

Once you’ve established a pain point—for example, a competitor is eating their lunch in a new market segment—craft your pitch and business case from the perspective of how you can solve their problems for them.  Bonus points if you can do so in a way that connects directly to increased revenue, profit, market and mindshare.  In this way, you will find that the gap between your companies is small, and the deal will go exponentially smoother and faster.

5.   Introduce competition into every deal.
This is a key point, and perhaps the most powerful technique of them all.  In every situation, getting some competitive heat on the deal will give you negotiating leverage, increase the tempo of discussions, and greatly raise the odds of a successful outcome.  Even if you’ve followed the advice from point #1 and zeroed in on your dream partner, opening up a dialogue with their competitors is well worth the effort. In addition, you should skillfully and subtly let your target partner know you are having talks with other firms.   This is the “art of the reveal,” and weaving in the knowledge that their rival may sweep the deal out from under them greatly helps level the playing field.

For example, I once worked with a mobile startup that needed to source both a carrier partner and a wireless chip vendor. We brought to the table dual assets of innovative technology and a ton of press buzz.  We initiated parallel discussion paths with two carriers and three chip manufacturers, even though we knew exactly who we wanted to work with from the outset.  The benefits of this strategy were clearly evident in the tempo of every meeting and in the tone of every term sheet. The deal was still a challenge—we were fighting the startup bias, after all—and there were a few heart-stopping moments where it looked like it would all fall apart.  But in the end, we got favorable pricing from our preferred partners, and did the deals in an accelerated timeframe.

6.   Be operationally ready to do a deal.
Startups are notoriously under-funded, under-staffed, and over-stressed.  Before going too far down the path with a partner, ask yourself whether you really can support the deal from both a business and technical perspective.  Can you spend weeks hammering out technical details and timelines?  Do you have the bandwidth and attention span to turn around multiple drafts of an MOU or LOI?  And of course, do you have the engineering bandwidth to actually implement the JV technology and nurture it through the launch and post-marketing support phases?

To note, this is a classic balancing act; being “operationally ready” at a startup is almost an oxymoron.  Many startups have struck game-changing deals before they were really prepared to handle them, and then hustled like hell to successfully pull things off.  Indeed, startups need a healthy level of outsized bravado in their DNA.  But if your answers to the several of the above questions are clearly “no” it may make sense to get a little further down the path before sinking time into partnership endeavors.

7.   Know when to cut bait and run.
This is a tough one to do well, but it’s a critical skill nonetheless.  Sometimes your company’s goals will shift, taking a proposed deal off the critical path.  Other times, you’ll be two-thirds of a way through the partnership negotiations when you realize it is not a strategic fit. The initial enthusiasm fades as you get into the details, and you realize that the technology integration hurdles are massive, or that your partner’s marketing channels are not as strong as they appeared.  Sometimes it’s simply cultural or personal—the thought of spending years with a partner who doesn’t “play well in the sandbox” gives you night sweats.

The challenge here is twofold.  First, it can be difficult to discern between deals where there is truly not a fit, and the normal struggles, politics, highs and lows that accompany any deal.  Second, in many cases you’ve already sunk a ton of time and money into the process, and it is emotionally draining to accept that it was all wasted effort.  However, time is the enemy for startups; the clock ticks faster when your funding is running out and markets are evolving rapidly.  Do the analysis, but trust your gut—if it’s clearly not going to work out, consider your efforts as sunk costs, extricate your firm as smoothly as quickly as possible, and move on to the next deal.  

In sum, business development is fun—happy hunting!

19 January 2010

Startup Valuation: How Much Is Your Company Worth?

Part of my job description involves prepping startups to raise capital. One of the most common issues that concern entrepreneurs is how to address the "Valuation Question."

I understand this concern; raising money puts a very un-ambiguous stamp of “worth” on what you’ve worked so hard to create. Thus, it is logical that entrepreneurs want to approach the negotiating table with a bullet-proof spreadsheet detailing and supporting their valuation down to the last dollar.

Which is exactly why they hate my answers to the question, “what is our valuation?”:
  • Startup valuation is an art not a science; and,
  • Your company is worth is what the market will pay for it.
They hate these retorts for several reasons; for one, it essentially means that valuation hinges on their negotiating skills (which is daunting since they’re going up against professional investors / negotiators). Second, these are fuzzy answers— not what they expect from a CFA with a graduate degree in finance.

Unfortunately, I cannot make it much less fuzzy. It’s not because I don’t understand valuation; on the contrary, I spent the first few years of my career doing nothing but valuations of technology companies.

But the challenge is that none of the traditionally-accepted valuation methods really apply to early stage startups. Let’s briefly review why:

Discounted Cash Flow Model: A DCF model “feels” the most robust because it is very quantitative and analytical, and it results in a single valuation number. In a DCF, we forecast several years of revenue and expenses, and then discount the resulting cash flow back to the present using a “venture capital expected rate of return.” The models are beautiful, sophisticated, and complex. They dazzle.

But here’s the problem: a skilled Excel wizard can make a DCF spit out any valuation they want. Because there is no (or very little) historical financial data with most startups, forecasts are pure conjecture and fantasy. In addition, the model is extremely sensitive; adjust the discount rate down slightly and our growth rate up, and suddenly your valuation doubles. No serious investor would ever pay much heed to this.

Cost-To-Recreate Model: This is just as it sounds—we back into an estimate of what it would cost to duplicate or recreate the company with one of like utility. It is analogous to a make-vs.-buy decision, and the premise is that a prudent investor would pay no more for an asset than its replacement or reproduction cost. As one simple example, we might estimate the cost in terms of the number of man-hours of programming required to write a comparably-functional software program. While this method also spits out a tangible, “hard” number, it doesn’t fully capture the future
potential of a business, and it doesn't reflect the value of intangibles like the brand (which can obviously be quite valuable).

Market Multiple Model: This is the most robust method and it is actually used in the venture world. With the market approach, we value a company by looking at recent sales or offerings of comparable companies, then we adjust the multiple to reflect specific characteristics of our company. This gets us closest to the answer above that “valuation is what the market will pay.”

However, here’s the catch: it is very difficult to find accurate data on truly comparable startup financings. Not only is it hard to find apples-to-apples comps, but funding valuation data is often kept close to the vest. While some companies report this—usually when they get a huge valuation round—most startups do not, and as private companies they are not required to do so. (To clarify, many companies report
how much they raised, but not at what valuation they raised it at). Even some of the very powerful databases we use such as Capital IQ do not always contain this data.

So, having crossed off traditional valuation models, what do seed and series A startups do? How do we best approach the question of valuation? Here are three methods:

1. Use Stage of Development As A Proxy: A startup’s path from idea to IPO can be charted as a series of major milestones (as well as hundreds of smaller stepping stones). At each milestone, a startup’s valuation rises as more and more risk has been removed from the business. Thus, one way to assess valuation is to look at where your company is at, and match it to typical valuation ranges for each stage. For example a funding-path for a web or software business may be as follows:

Different types of investors play at each round, and if the company is executing to plan, there is generally a sizable jump in valuation at each stage. For example, the increase in valuation between stages 1 and 2 – where we’ve eliminated most of the technology risk—is usually relatively slight. Between 2 and 3, we’ve proven that a market exists—someone will buy the product. A much larger segment of investors are interested at this stage. Between 3 and 4, customers are piling on, which leads investors to pile on—thus creating astounding valuations like we see with Facebook or Twitter.

2. Tell A Really Good Story: Because there are few really solid quantitative ways to value a startup, estimates of a company’s worth often come down to perception. This, in turn, comes down to how well you present your company in the form of your investor pitch and pitch deck. My rule of thumb here is simple: present the company in as favorable a light as possible, without misrepresenting it in any way. This includes how you position your company vis-à-vis the competition, what you choose to emphasize or call out with respect to opportunities and strengths, and so forth. As in sales, it pays to focus on the attractive and compelling parts of your business and the value your company brings. Pitch it with passion, while addressing any issues or ‘warts’ candidly and honestly (they will come out in due diligence anyway).

A corollary note is that
presentation matters. How you present the company to investors in the form of your pitch deck and business plan is a signal of how you will present the company to the outside world, and to future investors in later rounds. To elucidate this, I use the example of selling a car. A few simple things like a thorough cleaning, detailing and a good polish can spark an emotional response in the buyer and raise the valuation far more than the cost of such services.

The converse is true as well: a messy, unattractive, or problematic car will turn off most buyers; or, if buyers are still interested, they will use such flaws to beat down the price. This analogy carries through to due diligence: fixing a $20 rattling door handle preemptively removes that obstacle to a sale, just as cleaning up your startup’s capitalization table and IP assignment rights in advance will ensure the funding process goes that much smoother. In short, make it attractive and make it easy for the buyer to buy.

3. Put On Your Best Poker Face And Just Ask: Let’s assume that you have a SaaS company that has built a decent first version of the technology, launched it, and generated a base of initial customers (and corresponding metrics). You’ve eliminated most of the technology risk and some of the market acceptance risk, and you only have one or two gaps to fill on the management team.

Looking at the table above, you determine that Series A deals for companies with similar characteristics often fall into the $5 to $15M range. Your customer pipeline is filling up, and VCs have been receptive to your meeting requests; your pitch and slide deck are polished, and overall, you’re feeling good about your funding prospects. Thus, at the end of a pitch meeting, when asked what you think your valuation is, the best approach is to either avoid the question (saying you’ll let the market decide), or to state simply and without blinking, “we’re looking for a $12 to $14 million pre” (with "pre" signifying pre-money).

From my experience, if the ask is within the range of reason, there is usually not much further discussion. The VC takes note of it, and files the information away as a point for future negotiations. After all, it’s not like we’re
demanding a certain valuation and trying to justify it. We’re simply stating what we’re looking for. Continuing with the analogy of selling a car, the buyer probably knows the general price range for cars like yours, and if you’re within the relative range, then it comes down to how much he really wants the car. Whether he accepts the price you’re asking also comes down to how many other buyers are interested, which brings us to the next point…

3. Get Other Buyers In The Game: This is the biggie. The level of interest in a deal is the single most important factor influencing valuation (and for that matter, for negotiating everything else on the term sheet). In short, if you have just one investor interested, he or she sets the price, and you are free to accept it or walk—you are a price taker. If you have multiple investors interested, then your leverage increases tenfold, and you become a price maker. In such situations, we have effectively created a “market” for your stock—and in some cases, this can escalate to become a heated auction environment (which is the reason why some valuations catch fire and go through the roof).

In sum, a little knowledge (of comps and ranges), a little confidence (the “art of the ask”) and the ability to generate demand from multiple parties are your best tools to manage the valuation discussion and term sheet negotiations.

Remember: your company is worth is what the market will pay for it. Create a market for your startup, and you will have the leverage to get what you feel it is worth.

04 January 2010

In Praise of "Dumb Money"

I am frequently contacted by startup founders seeking help raising an angel round of capital. I give an explanation of what angels are looking for, point out a few of the various formal angel groups, and describe the growing army of “super angel” investors like Ron Conway or Aydin Senkut that has emerged in recent years.

And then I gently shatter their hopes and dreams by telling them there is no way in hell any angel will fund them; I tell them they are not ready to raise outside capital from professional investors.

I do this because of a common disconnect, a misperception of angels as mythical creatures willing to shoulder all the financial risk in a startup. Granted, angels are opportunistically driven by a desire to get in early. But the reality is that they are still
highly risk averse (especially since it’s their own money) and seemingly becoming more so (according to a recent NY Times article, total angel funding fell by 27 percent in the first half of 2009, and the average deal size shrank by 30%).

The point I try to drill home is that although angels play early in the game, they rarely invest in pure ideas or business plans. Instead, they tend to invest in entrepreneurs who have been able to get the ball rolling through their own hustle, creativity, and chutzpah. You may not have solved all the technical or market risks, but angels want to see that you are sufficiently resourceful to have built enough of “something” that they can see the shape it’s taking, and kick the tires a little.

So what do I suggest for those who are not ready for angels, and who don’t have enough personal savings to launch the business?

I tell them to seek dumb money.

This pejorative term comes from the fact that an investment in a pre-launch company is almost never rational when viewed by any traditional investment lens. Given the lottery-like odds that a pre-launch company will ever return money to its initial backers, dumb-money investments are more akin to a grant or donation than an “investment.”

But “dumb money” is often exactly what is needed at the idea stage of a business, and it usually means hitting up friends and family—people who know you well enough that they are willing to take a leap of faith on your ability to pull it off. In short, you are raising money from people who are willing to invest in you, as opposed to investing in the fundamentals of a deal.

I dislike this term, as it is both pejorative and a misnomer—anyone who can bankroll the $50k or $100k needed to get your startup off the ground has probably done quite well for themselves based on their own smarts and drive. They may not be savvy private equity investors, but they probably know a few things about business.

Further it neglects how important the friends-and-family funding economy is to a healthy startup ecosystem. Indeed, it is the invisible army of doctors, dentists, parents, grandparents, and great aunts who catalyze the dreams of wild-eyed entrepreneurs and who enable crazy ideas to come to fruition and change the world.

So this holiday season, let’s raise our glasses to the unheralded champions of entrepreneurship, the ones you don’t read about on TechCrunch but who in aggregate are more vitally important to the startup world than all the VCs combined.

And, as the liquid refreshments begin taking effect, and as you move in to seal the deal, let’s review a few tips to ensure the dumb money round does not become a disaster:

Understand The Risks: If you raise friends-and-family money and your startup fails—and odds are it will—you’ll still see your “investors” each Thanksgiving and at each wedding, baptism or bar mitzvah. Is this going to cause significant heartburn and family strife? Proactively visualize your father-in-law’s reaction to losing his money, and it’s effect on your relationship. Make sure you can stomach this before cashing his personal check.

Make Them Understand The Risks: Directly related to the above, you should temper your pitch by being painfully, explicitly candid about the risks of the venture. Talk through all the reasons the company might fail, and state that although you will do everything legally possible to make the business a success, the odds are that they will never see their money again. Is this something they are willing to accept? Perhaps more importantly, is this going to cause them financial hardship? If so, you’d do best to look elsewhere.

Structure It As A Loan: Selling a percent of your company at an early stage is exceedingly difficult, not only because you must issue shares, but because it generally implies you are setting a valuation. Further, a messy cap table—with many small investors who may or may not be “accredited”—can make it difficult to raise money later from professional angels or VCs. A better approach is to structure it either as a non-recourse loan, or as convertible debt (i.e., a loan that converts into equity once a valuation is negotiated later with VCs).

Paper It Up: Many friends-and-family rounds are done via lunch and handshake. In general, I think this is a mistake, and you are better served by drafting a written deal. It need not be overly complex, but it should state the amount being loaned or invested, repayment terms (if any), and an acknowledgement of the risks involved. The most valuable takeaway is that you’ll have something tangible that you can refer to later if things go awry or if perceptions diverge.

Go Like Hell: The best way to solve all of the issues above is to execute like hell and make the business a success. Granted, this should be a given, but building a startup is always a roller coaster ride with serious highs and lows, and many entrepreneurs want off when things get rocky. Taking other people’s money brings an additional level of obligation and pressure; it means you need to be more committed; it means you can’t easily walk away. In particular, this manifests itself in a sacrifice of personal life and freedom. But this is the deal with the devil you make when you take other people’s money. Further, for your investors, demonstrating that you gave it your all will lessen the pain of losing their money if the startup fails.

In sum, dumb money is what you need at the idea stage. But let’s come up with a better term for this critical bedrock of innovation. How about “concept capital”?